Corporate Governance and Risk-Taking in Pension Plans

In our paper, Corporate Governance and Risk-Taking in Pension Plans: Evidence from Defined Benefit Asset Allocations, forthcoming in the Journal of Financial and Quantitative Analysis, we examine whether good corporate governance leads to a larger allocation of pension assets to risky securities as compared to safe investments. Defined benefit (DB) plans are one of the most important private retirement schemes in corporate America. Although pension regulations require firms to establish separate trusts to manage and invest DB pension plan assets, these pension plans are owned by the sponsoring corporations and the plan asset allocations are made under the influence of, if not the direction and control of, the plan sponsors. Depending on the firm and plan characteristics as well as the market environment, firms may have different incentives in investing pension assets, namely, either risk-taking by allocating a larger share of plan assets to risky asset classes (e.g., equity) or risk management by investing heavily in safe asset classes (e.g., cash, government debt, and guaranteed insurance contracts).

Corporate governance plays an important role in corporate business operation and performance. Good corporate governance tends to hinder managerial discretion and puts pressure on managers to take more risk in making business investment decisions. We empirically evaluate whether good corporate governance leads to a larger allocation of pension assets to risky securities as compared to safe investments because such risk-taking enhances pension funding through higher investment returns and lowers pension contributions. We examine corporate governance mechanisms that measure investor protection by blockholder ownership or institutional ownership, and managerial entrenchment proxied by anti-takeover provisions.

We employ univariate and multivariate analyses to examine the asset allocation of 467 DB plans of 329 unique firms over the 1990-2006 period and find evidence that higher allocations of plan assets to equities and smaller shares to cash, government debt, and insurance company accounts are characterized by higher investment returns, lower pension contributions, and better pension funding. More importantly, firms with good external corporate governance, classified on the basis of a sample firm’s rank in the number of anti-takeover provisions in comparison with the sample median, take more risk by allocating about 9% more of firm-level pension assets to risky assets (i.e., equities) than those with poor external corporate governance. Our finding of a positive relation between good external governance and risk-taking in pension asset allocation holds at both the plan and firm levels after controlling for several other factors that are documented in the literature to have power in explaining pension asset allocation. The main underlying mechanisms appear to be higher investment returns and better pension funding status associated with higher equity and lower safe asset allocations. In addition, we also find some evidence that higher ownership concentration is associated with more risk-taking in pension asset allocation.

Besides contributing to the financial economics literature, our research has important implications for corporate investments and pension policy. Specifically, pension contributions could drain the defined benefits plan sponsors’ liquid resources that would otherwise be used to grow their businesses, especially for financially constrained firms. Our findings suggest a channel through which better corporate governance may improve overall investment policy of the firm with defined benefit pension plan, notably by altering the structure of the pension assets allocation toward risky assets firms can earn higher returns, improve the pension funding status, and lower pension contribution. The resulting savings can be invested in other corporate growth programs for the benefit of the shareholders. Our results also indicate that public policy should consider strengthening external and internal governance mechanisms to improve the financial health of private defined benefit plans.

The full paper is available for download here.